Wildenburg Holdings Ltd. v. Ontario (Minister of Revenue)!, 98 DTC 6462, [1999] 2 CTC 161 (Ont. C.J. (G.D.)), aff'd 2001 DTC 5145 (Ont CA)

Pitt J.:

The important issue raised in this appeal is whether a corporation can insulate itself from the impact of the “thin capitalization rules” in section 18(4) of the Income Tax Act (the “ITA”) by entering into what appears to be a partnership agreement, and thereby utilize the provisions of sec. 96(1) of the ITA, which permits a Partnership to compute its income for taxation purposes as if it were a separate person.

The Undisputed Facts

The appellant is a corporation incorporated under the laws of the Province of Ontario and at all material times was a resident of Canada for the purposes of the ITA and the Corporations Tax Act (Ontario) (the “Ontario Act”). All of the shares of the Appellant were owned at all material times by August Hermann Hatzfeldt Wildenburg Doenhoff (the “Shareholder”), an individual resident in Germany.

Orlando Corporation (“Orlando”) was at all material times a corporation incorporated under the laws of the Province of Ontario.

At all material times, the Appellant owned a 50% interest in a “Partnership” known as “the 1200 Meyerside Partnership”. The other 50% interest was owned by Orlando. The “partners” owned a parcel of land in Brampton to which title was held as the Appellant and Orlando “carrying on business in partnership under the firm name and style of ‘1200 Meyerside’”.

By instrument No. 365178, registered in the Land Registry Office at Brampton, the Appellant and Orlando granted a mortgage (the “Mortgage”) of the land to Metro International Inc., in Trust as security for a loan of $1,200,000.00. By a trust declaration dated December 15, 1981, Metro International Inc. declared that, with respect to the Mortgage, it was acting solely as a bare trustee for the Appellant’s sole shareholder.

The borrowed money was used by “the Partnership” to earn income from its business and property.

The Partnership paid the Shareholder interest (the “Interest”) annually from 1981 to 1985 pursuant to the Mortgage. On September 1, 1985, the Partnership repaid the loan in full.

Pursuant to subsection 96(1) of the ITA, the Partnership’s net income was calculated at the partnership level and its expenses (including the Interest) were deducted from the Partnership’s revenues. Each partner then reported their respective 50% share of Partnership income for income tax purposes.

The Appellant included in its taxable income for 1981-1985 its share of the “Partnership” net income, as calculated above.

The Respondent reassessed the Appellant in respect of the 1981-1985 taxation years, and included in the Appellant’s income 50% of the Interest paid by the “Partnership” to the Shareholder for each year (the “Allocated Interest”), purportedly based on subsection 18(4) of the ITA (which is incorporated by reference in the Ontario Act by sec. 11 of the Ontario Act).

Analysis

The respondent in its factum has properly defined the issues as follows:

1. Whether the Appellant and Orlando were partners in a partnership, 1200 Meyerside, or whether the relationship was one of joint venture?

2. Whether for the purposes of the application of subsection 18(4) of the ITA the mortgage loan made to the Appellant and Orlando was a debt to a separate person, the “partnership”?

3. Whether the “thin capitalization rules” in subsection 18(4) of the ITA restrict the interest deduction of the Appellant?

Issue I : Was There A Partnership? The Appellant entered in evidence a “partnership agreement” between the Appellant and Orlando dated November I, 1980. The following are some provisions of the agreement highlighted by the Respondent as causing some difficulty for the Appellant.

1.06 “Cash Flow” means that portion of the Gross Revenues available for distribution to the Partners from time to time after payment of the Partnership Expenses.

2.03 The purpose for which the Partnership is formed and the business of the Partnership shall be to acquire the Land and construct and lease the Building and thereafter to hold and operate the Property as part of the business of the Partnership.

3.04 The Partners agree that the Partnership shall not take any of the following actions without consent of both Partners:

(a) the sale, transfer or any other disposition, including without limitation a mortgage or other encumbrance of all or any part of or any interest in the Partnership Property:

(b) the partition of the Partnership Property or any part thereof or any interest therein;

(c) the borrowing of any sums of money by the Partnership;

(d) the guarantee both as a primary debtor or a surety by the Partnership of any debt or other obligation;

(e) the institution or settlement or compromise of any claim or litigation pertaining to the Partnership:

(f) the purchase or lease of any real property by the Partnership;

(g) the making on behalf of the Partnership of any Canadian federal or provincial elections or choices of methods of reporting income or loss for income tax purposes, or the filing on behalf of the Partnership of any Canadian federal or provincial income tax information returns;

(h) the approval of an annual budget for the Partnership;

(i) the incurring of any financial obligations or the making of any expenditure which exceeds the amount budgeted therefore by the Partnership by more than ten percent (10%):

(j) except as otherwise provided in this Agreement, the distribution of any Cash flow or any distribution pursuant to Article VIII hereof upon the dissolution of the Partnership; and

(k) any other matter or thing set forth in this Agreement that requires the consent of both Partners.

5.04 The Partners agree that Cash Flow shall be distributed by the Partnership to the Partners in their Partnership Shares monthly unless otherwise determined by both Partners. Distributions of Cash Flow, however, shall be subject to the provisions of Article X hereof.— which deals with default—

8.01 The Partnership shall dissolve:

(a) upon the sale and conveyance of all of the Partnership Property; or

(b) upon the written agreement of the Partners, together with the recording in the appropriate office public record of a Dissolution of Partnership, executed by all Partners.

9.03 Either Partner shall be entitled to complete any of the following Dispositions without the prior written approval of the other Partner (but on prior written notice):

(a) the sale or transfer by either Partner of its Partnership Interest to a third party established to the reasonable satisfaction of the other Partner not to be dealing at Arm’s Length with the selling or transferring Partner;

and

(b) the sale or transfer of its Partnership Interest under either a Matching Offer or Sale Offer or a purchase.

The uncontradicted evidence submitted by the appellant was that it was the intention of the parties to have a long-term relationship, but the purchase and management of each property would require a separate partnership agreement.

The interest which is the subject-matter of the dispute was paid pursuant to the mortgage referred to earlier, which contained the following provision:

The Mortgagee hereby for itself and its successors and assigns covenants and agrees that the liability of Orlando Corporation pursuant to this Mortgage is limited to fifty percent (50%) of the principal sum and other monies from time to time secured hereunder (the liability of Wildenburg Holdings Limited being for the balance) and FURTHER that upon any sale of the said lands by the Mortgagee pursuant to this Mortgage, the liability of Orlando shall be limited to the amount representing fifty percent (50%) of any deficiency (the liability of Wildenburg Holdings Limited being for the balance).

The Respondent argues that the partnership agreement has most of the hallmarks of a Joint Venture, which is essentially a partnership established to fulfill a particular business undertaking within a limited time. It is usually limited to the development in question, members have an unfettered right to dispose of their interest in the project and important decisions involve a system of mutual management and control. See Woodlin Developments Ltd. v. Minister of National Revenue, [1986] 1 C.T.C. 2188 (T.C.C.).

Although not raised in argument the habendum in the transfer to the property dated November 30, 1980, by which the parties became owners, does not describe the property as being held as ‘’Partnership Property” and as was noted earlier in the mortgage, the liability of Orlando is limited to 50%, thereby evincing an intention to treat the liability of the partners differently from that provided for in the Partnership Act R.S.O. 1990 (see Sec. 10 which provides that a partner is liable for the debts of the Partnership) and at common law. It is well established that whether any particular property used in a partnership business is or is not partnership property does not depend on how the title happens to be held but is a question of fact based upon the intention of the parties.

Issue 2: Whether for the purposes of the Application of subsection 18(4) of the ITA, the loan made to the Appellant and Orlando was the debt of the Appellant and Orlando, jointly, or was it the debt of a separate person, the partnership?

Subsection 18(4) of the ITA, S.C. 1970-71-72, c. 63 which was incorporated by reference into the Ontario Corporation Tax Act reads as follows: 18 -(4) Notwithstanding any other provision of this Act, in computing the income for a taxation year of a corporation resident in Canada from a business or property, no deduction shall be made in respect of that proportion of any amount otherwise deductible in computing its income for the year in respect of interest paid or payable by it on outstanding debts to specified non-residents that

(a) the amount, if any, by which

(i) the greatest amount that the corporation’s outstanding debts to specified non-residents was at any time in the year,

exceeds

(ii) 3 times the aggregate of

(A) the retained earnings of the corporation at the commencement of the year, except to the extent that those earnings include retained earnings of any other corporation,

(B) the corporation’s contributed surplus at the commencement of the year, and

(C) the greater of the corporation’s paid-up capital at the commencement of the year and the corporation’s paid-up capital at the end of the year.

(b) the amount determined under subparagraph (a)(i) in respect of the corporation for the year.

[emphasis mine]

Section 96(1) of the ITA also incorporated by reference into the Ontario Corporation Tax Act reads as follows:

96.(1) Where a taxpayer is a member of a partnership, his income, net capital loss, non-capital loss and restricted farm loss, if any, for a taxation year, or his taxable income earned in Canada for a taxation year, as the case may be, shall be computed as if

(a) the partnership were a separate person resident in Canada;

(b) the taxation year of the partnership were its fiscal period:

(c) each partnership activity (including the ownership of property) were carried on by the partnership as a separate person, and a computation were made of the amount of

(i) each taxable capital gain and allowable capital loss of the partnership from the disposition of property, and

(ii) each income and loss of the partnership from each other source or from sources in a particular place

[emphasis mine]

The Tax Court in the case of No. 630 v. Minister of National Revenue (1959), 22 Tax A.B.C. 91 (Can. Tax App. Bd.) reaffirmed the well-known legal principle that a partnership was merely a combination of persons for the purpose of carrying on a particular trade or trades and in no sense strictly speaking a legal entity.

What is more, in answering the question who was responsible for the payment of the debt to the mortgagee, one need not necessarily invoke the aid of legal analysis, as the parties themselves provided the answer in the mortgage document by stipulating that Orlando would be liable for only 50%, and the appellant for the balance. For Orlando therefore, in respect of this creditor only, its risk is contractually limited.

Since there is no common law basis for the appellant’s contention that the debt is a partnership debt rather then a debt of the partners, the appellant relies entirely on the provisions of sec. 96(1) of the ITA. In substance the appellant argues that once a corporation is found to be a member of a partnership for the purpose of computing its income for income tax purposes, the Minister is estopped from treating that corporate member of the partnership as a corporation in respect of another provision of the Act which purports to restrict its right to make deductions in computing its income. Ironically the appellant finds some support for this argument in a response given by Revenue Canada at the 44th tax conference of the Canadian Tax Foundation, reported on pages 54.8 and 54.9 of the report of the 44th Tax Conference (Toronto: Canadian Tax Foundation 1993).

The question and answer follows:

Q.12 Thin capitalization

A Canadian Corporation is related to a Non-Resident Corporation that has made a LOAN to a Non-Canadian Partnership of which the Canadian Corporation is a member. Do the thin capitalization rules in subsection 18(4) of the Act apply with respect to the debts of and interest payable by the Non-Canadian Partnership?

Department’s Position

Where a taxpayer is a member of a partnership, the rules in subsection 96(1) of the Act apply in respect of the partnership for purposes of computing, inter alia, the taxpayer’s income or taxable income earned in Canada. Under paragraph 96(1 )(a), the relevant computation is made as if the partnership were a separate person resident in Canada. Under paragraph 96(1)(f), the taxpayer’s income from the partnership for a taxation year is the taxpayer’s share thereof.

In circumstances where a non-Canadian Partnership (whose members include a corporation resident in Canada) has received a loan from a non-resident person, the rules in subsection 96(1) are relevant in determining how the thin capitalization rules would apply. Subsection 18(4) would be applied at the partnership level - that is, the partnership, not the partners, would be considered to have received the loan. Subsection 18(4) would therefore not apply in these circumstances since the loan would not have been received by a corporation resident in Canada. Where, however, it may reasonably be considered that the formation of the partnership was primarily to avoid the application of subsection 18(4) to interest paid on loans made the partnership, the application of subsection 245(2) will be considered.

The issue before me is somewhat different, and in any event Revenue Canada’s responses are not dispositive of issues before the courts.

The following appears in CCH, Canadian Tax Reporter, Volume 3 under the heading Partnerships par. 13,026:

The basic concepts governing the taxation of partnership income are set out in subsection 96( 1 ). This provides for the computation of income (or loss, capital gain, etc.) by a member of a partnership as if certain things were so, such as that the partnership was a person resident in Canada with a taxation year identical to its fiscal period. The subsection does not deem or otherwise force a partnership to be either a person or a taxpayer; on the contrary it appears to accept that a partnership is neither a person nor a taxpayer and is not to be treated as such for tax purposes. The subsection does, however, require the computation of the income of the taxpayer who is a member of a partnership to be calculated on certain essentially I hypothetical assumptions, namely that the partnership is a person with a taxation year. The insistence that a partnership is not made a person or taxpayer under the Act may seem artificial, but it has important consequences and should always be kept in mind. [emphasis added]

Although in Norco Development Ltd. v. R. (1985), 85 D.T.C. 5213 (Fed. T.D.) the court was concerned with the provisions of the ITA dealing with the computation of tax payable, rather than the computation of income, the Court’s language is instructive. The Court stated at page 8:

In my opinion, the partnership, Noort Developments, is not a legal entity. Section 96 of the Act provides rules for the computation of partnership income. The partnership is envisaged as a separate person solely for the purpose of measuring the flow of income to the individual partners which is then taxed in their hands. It is the partners and not the firm itself which are the alleged subject of Taxation.

Both by statute (see the Partnership Act R.S.O. 1990 sec. 1 ) and at common law (see Lindley & Banks on Partnership, 17th Edition P.8) a partnership is the relation that subsists between persons carrying on a business in common with a view to profit. In my view a partnership can neither be a debtor, a creditor or for that matter a taxpayer and sec.96(1) does not change that.

Issue 3: Do the thin capitalization rules (sec. 18(4)) of the ITA restrict the interest deduction of the appellant?

By their arguments the parties impliedly agree that the rules will apply unless the court finds that the application of the deeming provisions of sec. 96(1) negates the effect of the corporate status of the appellant for the purposes of the section.

Disposition

While there are some reasons for characterizing as a joint venture the relationship between the appellant and Orlando for the acquisition and development of the single piece of real estate involved here, I find that there is enough evidence to warrant its characterization as a partnership.

However in the circumstances outlined in the facts agreed upon by the parties, it seems clear that the mortgage loan was a debt of the appellant and Orlando with the latter’s responsibility being limited to one-half, and not a debt of the partnership, although secured by property owned by the partners.

It is noteworthy though not critical that the appellant, when recording the “net income” of the partnership in its income for tax purposes, did not include a “net profit” figure in its income, but rather, as the respondent puts it “broke out” the “net” figure into various components which accounted for the “net” income allocated to it. In consequence of which, the appellant included and set out its share of the interest deduction in full, in its tax deduction, as a reduction in its overall income subject to Tax.

Further I am not persuaded that sec. 96(1) is a bar to the application of the rules in sec. 18(4) to the appellant also for the reason that the opening words of sec. 18(4) are “notwithstanding any provisions of this act ... no deduction shall be made in respect of that proportion of any amount otherwise deductible in computing its income...”

Finally “avoiding unjust or unacceptable results is an essential part of the Court’s task in interpreting statutory language. See Bapoo v. Co-opera- tors General Insurance Co. (1997), 36 O.R. (3d) 616 (Ont. C.A.) at 625. Orlando receives the contractual benefit of a special limitation on its liability, while the appellant, by virtue of its partnership relationship with Orlando, claims a statutory exemption from the thin capitalization rules. The possibilities for abuse are limitless as the right to partnership status cannot be affected by the ratio of the partnership interests or the division of liabilities between the partners approved by the creditor. The objective of sec. 18(4) to (8) of the ITA is to prohibit the avoidance of tax by Canadian corporations with a significant interest owned by foreigners, who use debt rather than equity to achieve the objective. In my view, the deeming fiction utilized in sec. 96(1) for administrative reasons was not intended to and cannot be used to negate the objective of the thin capitalization rules in these circumstances.

The appeal is dismissed.

Costs

Since the issue appears to be novel I am not inclined to award costs. However, if the parties desire, the respondent may make written submissions Within 15 days of the release of these reasons, and the appellant within 15 days thereafter.

Appeal dismissed.